Preparing for IRS Scrutiny of Executive Compensation

Article

As the Internal Revenue Service (IRS) increases scrutiny of executive compensation amounts, compensation professionals need to proactively advise their clients on how to avoid this unwanted attention.

Four types of entities are being examined by the IRS and therefore need proactive advice.

First, closely held C corporations are being audited to determine whether they have overpaid their shareholder-employees. These corporations must pay income tax on their profits, and can then distribute nondeductible dividends to their shareholders. The shareholders must pay income tax on the dividends they receive, so there are two levels of tax. Since C corporations are allowed to deduct only “reasonable” amounts of compensation paid to shareholder-employees, examiners are looking for disguised dividends, which is corporate profits being deducted as if it is compensation. Since a dividend is not tax deductible but compensation is, the IRS may treat the excessive portion of unreasonable compensation as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest and penalties.

Conversely, S corporations are being audited to determine whether they have underpaid their shareholder-employees. The profits of S corporations are not taxed at the corporate level. Instead, the shareholders must include their respective shares of the corporation’s income on their individual income tax returns. So there is only one level of income tax. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions. Since compensation is subject to payroll taxes but distributions from S corporations are not, some tax savings can be realized by simply reducing shareholder compensation and increasing distributions. But S corporations are required to pay reasonable compensation to their shareholder-employees.

Nonprofit organizations are the IRS’ third area of focus. Since key employees may be able to increase their own pay levels, these nonprofits are often audited to determine whether they have paid unreasonably high compensation amounts. When the IRS finds that insiders have abused their authority by setting their own compensation at unreasonable levels, excise taxes are imposed as a result of these “excess benefit transactions.” Therefore, compensation professionals should proactively caution any charitable boards they may serve on a pro bono basis, as well as their nonprofit clients.

Publicly traded corporations are the fourth group being examined. The Internal Revenue Code (Code) includes important requirements that must be met for these companies to deduct the amounts they pay their top executives. And since public companies must publish their executive compensation tables, shareholders and the media can also become alarmed when they see the size of the pay packages.

Executives are often surprised and feel personally insulted when an IRS auditor challenges their pay. In response, they may blame compensation professionals for not forewarning them. To prevent such frustration, a few simple steps can be taken.

When an individual personally guarantees the employer’s debts, a guarantor fee should be computed separately.

Advice for Closely Held C Corporations

If a business owner is underpaid when cash flow is weak, he or she may be entitled to catch-up pay later. ¹ The directors should memorialize such arrangement in their minutes and consider including the liability on the balance sheet. If the company does not treat the deferred compensation as a real liability, the IRS may not either. They must also be careful to comply with Code Sec. 409A, which provides strict requirements for nonqualified deferred compensation plans.

Encourage business owners to develop a written compensation plan in advance and make note of all shareholders, directors and officers who approve it. To see how such approval can go a long way toward establishing the reasonableness of the plan, see the Tax Court’s explanation in Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286.

The compensation plan should include a method or formula for determining incentive amounts. Year-end bonuses are lightning rods for IRS examiners since they may be drawn from accumulated cash that appears to be profits. A bonus should be tied to performance and not simply to the amount of cash in the bank at year-end. Good notes are needed to explain how bonuses are earned and why they are worthwhile for the employer. These records may be your client’s best friend when an IRS challenge comes.

Include nonshareholders and nonfamily members in the bonus pool when appropriate. If year-end bonuses are paid only to shareholders and their relatives, the amounts may appear to be more like dividends than compensation. And be certain that bonus amounts are not tied to ownership in any way. For example, an officer who owns 20% of the company’s stock should not be assured of receiving 20% of the year-end bonus pool.

A bonus plan should be based on incentives related to the company’s goals. For example, if revenue growth is a major goal, bonuses may be tied to increasing sales; the senior management team may get a bonus pool of 15% of the amount by which revenue exceeds prior year revenue. The CEO may get 30% of the pool, the President may receive 20% and each Vice President may earn 10%. Basing bonuses on a growth rate or net income is much safer than basing it on the cash balance. For practical business reasons, provisions should be included in the bonus plan document, allowing the board to reduce the awards to the extent that payment of the bonuses would decrease the current cash balance below the amount needed for working capital, expansion and debt service. The board should also be able to delay payment of some or all of the bonuses if it deems it necessary to protect the company or to comply with loan covenants, government regulations or contract requirements.

Another trigger point is a loan from a company to a shareholder. Auditors commonly examine such loans to see if they may actually be additional compensation or dividends that have been recorded as loans for tax avoidance. Such loans should be discouraged, especially if they will not be repaid within a year or are made without a good business reason. But when a company does loan funds to a shareholder, the parties should be encouraged to sign an enforceable note that bears a reasonable interest rate and is secured by appropriate collateral.

To help prevent bonuses from looking like dividends, closely held C corporations should consider paying small dividends every few years. When challenging a shareholder’s high pay, the IRS has a stronger argument if the company has never (or not recently) paid a dividend to its shareholders.

One of the hottest audit issues arises when a key employee, such as the founder of a company, begins to move toward retirement. Once he or she starts reducing work hours and transitioning major responsibilities to others, a reduction in pay should be considered carefully. Since a pay reduction is a sensitive subject, anyone who values their relationship with this key individual may be reluctant to bring it up. But compensation professionals need to step up and say whatever needs to be said.

Shareholders may see these steps as overkill, but complying with these tips can make a world of difference. If the IRS is successful in reclassing a large portion of a shareholder’s pay, the company should be prepared to show that it made “a reasonable attempt” to comply with the tax law so it can avoid a negligence penalty under Code Sec. 6662.

A company may be liable for the Sec. 6662(a) and (b)(1) and (2) accuracy-related penalty when the IRS determines that a portion of its tax underpayment was due to either a substantial understatement of income tax or negligence.

There is a “substantial understatement” of income tax for any tax year when, in the case of corporations (other than S corporations or personal holding companies), the amount of the understatement exceeds the greater of (a) 10% of the tax required to be shown on the return for the tax year or (b) $10,000. ² Sec. 6662(a) and (b)(1) impose a penalty for negligence or disregard of rules or regulations. Under Sec. 6662(c), “negligence” includes “any failure to make a reasonable attempt to comply with the provisions of this title.”

Under case law, negligence is “a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances.” ³

There is an exception to the Sec. 6662(a) penalty when a company can demonstrate (a) reasonable cause for the underpayment and (b) that the company acted in good faith with respect to the underpayment. See Code Sec. 6664(c)(1). Regulations under Sec. 6664(c) provide that the determination of reasonable cause and good faith “is made on a case-by-case basis, taking into account all pertinent facts and circumstances.” See Sec. 1.6664-4(b)(1).

Reliance on the advice of a professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a Sec. 6662(a) penalty. ⁴

Case law sets forth the following three requirements for a company to use reliance on a professional adviser to avoid liability for a Sec. 6662(a) penalty:

Since executive compensation is such a complex subject, and usually involves large amounts, some companies rely on the three requirements above for protection against nondeductible penalties.

Advice for S Corporations

For employment tax purposes, wages are defined as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash,” with certain exceptions. ⁶ Regardless of how the corporation characterizes payments made to a shareholder, the critical fact is whether a payment is actually received as remuneration for services rendered. ⁷ A shareholder who performs more than minor services for a corporation and who receives remuneration in any form for those services is considered an employee, and his or her wages are subject to employment taxes. ⁸

Some S corporations take aggressive positions and pay no compensation to their shareholders. The IRS can pick up on this quickly since there is a separate line on page 1 of the S corporation income tax return (Form 1120S) for officer compensation. When no compensation at all is paid to any employees, encourage the filing of payroll tax returns anyway. They can simply show zeroes on the forms. Then, if the IRS determines that some compensation should have been paid during those periods, the company should at least be able to avoid the stiff penalty for failure to file payroll returns each quarter.

In family-owned businesses, it is common to give glamorous titles to family members who do not play key roles in the business. The thinking is that a shareholder who is going to receive little or no compensation may be satisfied instead with a big title. At first glance, this seems like a harmless practice. However, the IRS may use those titles when obtaining comparability data. Published opinions from recent tax court cases have shown heavy emphasis on using comparability data to determine market rates of pay. When comparing one’s pay to others in the same industry who have that same title, the IRS may conclude that a shareholder was underpaid. An adjustment to one shareholder’s pay may result in penalties for failure to withhold taxes and for failure to deposit the taxes that should have been withheld. Furthermore, an adjustment to just one shareholder’s pay could result in distributions for that period becoming disproportionate. Since S corporations are generally required to make distributions to shareholders on a pro rata basis (based on stock ownership), an increase in one’s pay, with a corresponding decrease in that shareholder’s distribution, can create disproportionate distributions. In a severe case, such disproportionate distributions could terminate the company’s S status.

Advice for Nonprofit Organizations

The IRS now keeps a close eye on charities and social welfare organizations to ensure that their tax-exempt status is not abused. One of the primary factors the IRS examines is the amounts of compensation and benefits provided by these tax-exempt organizations to their key employees.

The IRS believes that some officers and other employees may be taking advantage of their influential positions by setting their own compensation at above-market levels. The IRS has begun a widespread initiative to find those overpaid individuals.

The IRS is primarily using Code Sec. 4958, which allows them to impose excise taxes on the excessive portion of compensation paid to a charity’s employee. These excise taxes are referred to as “intermediate sanctions” since they are less severe than having the IRS revoke the charity’s tax-exempt status.

These excise taxes are aimed at unreasonable compensation paid to a “disqualified person.” A disqualified person is anyone who was “in a position to exercise substantial influence over the affairs” of the tax-exempt organization at any time during the 5-year period prior to the transaction, and the family members of any such person. Note that it is not necessary that the person actually exercised substantial influence, only that he or she was in a position to do so.

Overpaid independent contractors may be subject to the excise tax also. This could include consultants, CPAs and attorneys if they meet the definition of disqualified person.

The Code refers to the unreasonable portion of compensation as an “excess benefit transaction” because the individual is getting a benefit (compensation) in excess of the value of the services he or she provides for that compensation.

Expect the IRS to look closely at compensation amounts paid to the following: officers who also sit on the charity’s Board of Trustees, relatives of major donors, long-term employees who have cut back their hours, employees who receive performance bonuses and anyone who has a hand in setting his or her own compensation level. Certain industries are of special interest to the IRS. For example, hospitals are often examined because market conditions have pushed their officers’ compensation to higher levels in recent years.

Under Code Sec. 4958(a)(1), the IRS can impose a 25% excise tax on the unreasonable portion of an individual’s compensation. (This excise tax is in addition to federal and state income taxes, and FICA tax the employee has to pay on that compensation.) If the unreasonable portion is not repaid promptly after the 25% tax is imposed, Sec. 4958(b) provides for an excise tax equal to 200% of the unreasonable portion.

In addition, Code Sec. 4958(a)(2) allows the IRS to impose an excise tax on an “organization manager” (officer, director or trustee) who participated in permitting the unreasonable compensation, unless such participation was not willful and was due to reasonable cause. This tax is 10% of the unreasonable portion of the compensation. It was limited to $10,000 per excess benefit transaction until the Pension Protection Act of 2006 raised that limit to $20,000. Those organization managers who knowingly allow the excessive compensation are jointly and severally liable for this excise tax. Of course, the last thing any volunteer board member wants is to be personally exposed to a tax.

Note that both the 25% and the 10% excise taxes are imposed on the individuals, not the charity.

To let everyone know that they are serious about this, the IRS announced that it was assessing over $21 million in Sec. 4958 excise taxes on 40 disqualified persons and organization managers at 25 charities.

In addition to the monetary impact, publicity resulting from these penalties can be disastrous for a charity.

For all these reasons, charities need to be very careful about how much they pay and how the amounts are determined. However, setting levels of compensation for key employees is difficult for charitable Boards of Trustees since most board members are not familiar with the complexities of compensation analysis. And determining appropriate cash compensation levels for key employees at a charity may be more challenging than doing so at for-profit companies since charities do not offer stock options, profit-sharing plans and some of the other incentives offered to executives at for-profit entities.

Yet pay levels and benefits at charitable organizations must keep up with the market to prevent turnover, since turnover among key employees is costly, disruptive and damaging to donor relations.

Many charitable boards need guidance on pay levels due to the subjective nature of determining reasonable compensation, complex facts and the desire to avoid IRS scrutiny. An opinion letter from an independent party can give board members reassurance that pay levels are in line with the market and help avoid the excise taxes by creating a “rebuttable presumption” that the compensation is reasonable.

If the compensation is presumed to be reasonable under the excess benefit rules, Sec. 4958 excise taxes can then be imposed only if the IRS develops sufficient contrary evidence to rebut the charity’s evidence. In other words, the burden shifts to the IRS to prove that the compensation was unreasonable.

The charity’s board must meet three requirements to create a rebuttable presumption that compensation is reasonable:

A qualified compensation consultant can help the board meet these requirements by providing comparability data and documenting it in an opinion letter. In preparing opinion letters, the compensation professional should take into consideration all relevant facts and circumstances including but not limited to the following:

Other relevant factors usually include the size of the organization, the geographic area it serves, and the qualifications and duties of the employee.

The opinion letters serve another important purpose. Reg. 53.4958(d)(4)(iii) provides protection for the organization managers against the 10% excise tax even if the compensation is determined to be unreasonable. To get this protection, the managers must obtain an opinion letter stating that the compensation consultant believes that if the compensation amount is challenged by the IRS, it would “more likely than not” be upheld in court. Other requirements must be met as well. Although this does not guarantee that the compensation will not be found to be unreasonable, obtaining and using such an opinion letter can protect the officers and board members from personal exposure to the 10% excise tax.

U.S. Treasury Department Circular 230 requires that certain disclosures be included in the opinion letter. Under Sec. 10.35(e)(3), the disclosure usually includes a statement saying that the letter contains a “limited scope opinion” as defined by Circular 230 (Title 31 Code of Federal Regulations, Subtitle A, Part 10, revised as of September 26, 2007). The letter also includes a statement that the opinions expressed in the letter are limited to the one or more federal tax issues addressed in the letter, and that additional issues may exist that could affect the federal tax treatment of the transaction or matter that is the subject of the opinions and the opinions do not consider or provide a conclusion with respect to any additional issues; and, with respect to any significant federal tax issues outside the limited scope of the opinion, the opinion was not written and cannot be used for the purpose of avoiding penalties.

The opinion letter should also include a statement of independence from the compensation professional.

Advice for Publicly Traded Companies

Due to the public outcry over executive compensation at public companies, the federal income tax laws impose limits on amounts that can be deducted by the paying company.

Sec. 162(m) of the Code limits a publicly held corporation’s tax deduction for compensation paid to a “covered employee” to a maximum of $1,000,000 per year.

A corporation is publicly held if it has any class of common equity securities required to be registered under Sec. 12 of the Securities Exchange Act of 1934.

A “covered employee” is an individual who is the corporation’s CEO or one of the four highest compensated officers for the year, other than the CEO.

Officers leaving before the last day of the tax year with no intention of returning are not considered to be covered employees. Compensation paid to these former officers is therefore not subject to the deduction limit of Sec. 162(m).

Certain types of compensation are not subject to the $1,000,000 limit and are not included in the calculation:

Since few senior executives are paid commissions, many companies rely heavily on the exception for performance-based compensation. To meet this exception, the goals must be approved in advance by a compensation committee of the board of directors. That committee must include at least two outside directors. Furthermore, the goals must be disclosed to shareholders and approved in advance by a majority of the shareholders. The compensation committee must certify that the performance goals were met before payment is made. The goals must be objective, such as increasing the company’s stock price, market share, sales or earnings per share to certain levels. Simply maintaining the current stock price is enough, but continued employment with the company alone is not enough.

The $1,000,000 limit is reduced by any amount disallowed as a deduction under Sec. 280G, which applies to golden parachute payments (discussed below).

Stock options and stock appreciation rights are generally not included in compensation for purposes of Sec. 162(m) if they meet the requirements for performance-based compensation. However, some grants of restricted stock may not qualify for the exclusion, depending on the circumstances. ¹⁰

The regulations under Sec. 162(m) are lengthy but should be perused before executive compensation plans are finalized by a publicly held company.

The federal tax laws also impose limits on golden parachute arrangements. These plans typically provide for large cash payments to a corporation’s top executives if those individuals are terminated due to a change in the control of the company.

Years ago, these payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Code Sec. 162. Due to controversy over large executive pay packages, the Tax Reform Act of 1984 added Sec. 280G to the Code.

Sec. 280G provides that no deduction is allowed for any “excess parachute payment” paid as a result of a change in control of the corporation or a change in the ownership of a substantial portion of its assets (“change of control”). The payment may be to an employee, independent contractor or other person who performs services for the company and is an officer, shareholder or highly compensated individual. ¹¹

In addition to the loss of a deduction for excess parachute payments under Sec. 280G, Code Sec. 4999(a) imposes a 20% excise tax on the recipient of an excess parachute payment. Since an excess parachute payment would be taxed as ordinary income, the total tax on the recipient may exceed 65%. This is because he or she must pay federal income tax, Medicare tax, the 20% excise tax and state and local income taxes on that income.

If the payment is made while the individual is still an employee, the employer must withhold the full 20% excise tax. ¹²

The rules for determining an “excess parachute payment” are somewhat complex. The first step is to determine whether a “parachute payment” even exists. A parachute payment is defined as any payment in the nature of compensation to an officer, shareholder or highly compensated individual that is contingent on a change of control, if such payment exceeds a dollar figure equal to 3 times such person’s “base amount.” For these purposes, the base amount is an individual’s average annual compensation for the 5 taxable years ending prior to the year of the change of control.

If a parachute payment exists (the aggregate amounts contingent on a change of control exceed three times the base amount), the excess parachute payment is the entire portion of such payment that exceeds the base amount.

Notice that if the contingent payments exceed 3 times the base amount, by even 1 dollar, the entire amount of those contingent payments in excess of the base amount is an excess parachute payment subject to the loss of deduction and the 20% excise tax.

For example, let’s say that Pam’s average annual compensation for the prior 5 years was $400,000. On a change of control and her impending termination, she is to receive a parachute payment of $1,250,000. Since this amount exceeds 3 times her base (by $50,000), the entire portion in excess of her base amount is an excess parachute payment. Therefore, $850,000 is nondeductible by the company. And Pam must pay an excise tax of $170,000 (20% of $850,000). Note that if the payment to her had been $1,200,000, it would have all been deductible and none would have been subject to the excise tax.

Sec. 280G applies primarily to corporations whose stock is readily tradable on an established securities market. ¹³ Although the golden parachute rules were intended to deal with perceived abuses at publicly traded companies, these rules can also apply to closely held companies. There are exceptions in Sec. 280G(b)(5) that make Sec. 280G apply to non–publicly traded corporations unless the shareholders approve the payment by a super majority vote of more than 75% and there was adequate disclosure to shareholders of all material facts concerning all payments that would otherwise be parachute payments.

Also, note that if an agreement to pay was drafted or modified within a year prior to the change of control, it is presumed to be “contingent on a change of control” unless clearly shown not to be.

In the case of stock options that provide for accelerated vesting on a change of control, the regulations provide a method for calculating the value of such acceleration.

Payments to or from a qualified retirement plan are not considered to be parachute payments. ¹⁴ However, any compensatory payment made in violation of securities laws may be treated as a parachute payment. ¹⁵

Code Sec. 280G(e) was added to provide special rules for employers participating in the troubled assets relief program.

Any amount paid for personal services to be rendered on or after the date of the change in control is not considered to be a parachute payment if the company establishes by “clear and convincing evidence” that the amount is “reasonable compensation.” There is a similar exception for reasonable compensation paid for services rendered before the change of control.

In summary, there are many potential tax traps to avoid while designing parachute payments. The IRS regulations under Sec. 280G were written in a question and answer format. Although these regulations are lengthy, they should be perused carefully before any agreement providing for a parachute payment is finalized or modified.

Conclusion

Executive compensation is both complex and controversial. And it is especially sensitive and difficult to address after an IRS auditor has arrived and begun an inquiry. To avoid frustration, embarrassment and monetary penalties, compensation professionals should take the lead in helping educate clients and minimize the risks. Perhaps more important, we should ensure that the amounts paid are not more than the amounts that were actually earned.